Thursday, February 04, 2010

Milton Friedman on Steel Tariffs and Trade in 1978

Milton Friedman gives a concise and lucid argument for free trade at Utah State University in 1978.

At this link, you can watch Nucor (America's largest steel producer) CEO Dan Dimico's (salary of $3 million per year) argue on "60 Minutes" for trade protectionism for the U.S. steel industry. It gets interesting starting about 8:30 when Dimico responds to being called a protectionist by Leslie Stahl.

I don't know about the classes, but I believe the "Free to choose" series is still online, and interesting.

In this particular dialogue, I see two weaknesses in Friedman's analysis: first, the assumption of full employment that Friedman makes (that jobs lost in one place will be gained in another) is simply an (important) assumption. My understanding is that Samuelson's analysis continues when that assumption fails: Friedman's does not. Second, China and other Asian countries are not in net spending dollars either in America or abroad. However, they are potentially getting a return on their dollars by lending them: unless we plan not to pay the interest. Obviously, in the long term, they must either take a loss or start spending, but a lot can happen in "the short term".

I agree with Dr. Friedman's analysis, but have a follow-up question. Let's assume gov't subsidies of steel in Japan, and displaced US steel employment is absorbed by other industries. The US consumer benefits from lower steel prices. But what happens when the Japanese steel industry, now enjoying decreased US competition, decides to raise price above the previous US level? The consumer is worse off. I suppose that creates opportunities for new competition at lower price points, but I would think the cost of entry into the industry is prohibitive.

A common belief is that big companies will sell below cost to drive out their competitors and then raise their prices. This is a fallacy and there are few professional economists who believe otherwise. For a simple explanation, watch this video:http://www.youtube.com/watch?v=V6dD-ifIr8s

I don't think so. Dr Friedman makes two points after 4:40:1. Don't try to produce something that is counter to your natural specializations2. If a trade partner really wishes to sell you something at an absurdly cheap price, you should simply buy it and be grateful

For #1, this ignores that comparative advantage often isn't "natural". In many cases, technological comparative advantage is built on nothing but experience: the greatest "natural advantage" much of Asia ever had in manufacturing was a nationalistic determination to be in manufacturing, but having made the investment, they are now quite competent at it, subsidies or no. Also, once you have an advantage in one particular competency, there are splash effects and natural synergies to related areas.

For #2: This falls back to my point on full employment. If you have full employment, cheap stuff does you no harm. If you do not, great quantities of cheap stuff may do great harm to your ability to develop an industry. Developing nations with smart leadership understand this.

What does it matter whether the Chinese spend their dollars in the US or loan those dollars to others (especially the US government) who then spend them in the US? The effect is the same, at least in the short term.

As for your distinction between "natural" and non-natural specializations, I'm not convinced that it matters as much as you seem to think it does. Regardless of whether a current specialization is the result of climate, geography or past government policy, the fact that it is a current specialization is what matters.

What is the difference between spending earned and borrowed cash? Debt. In the short term, the effect is the same for Americans, but in the long term, wildly different. Not only do you get the drag of debt on the economy, but you artificially skew American production towards non-tradeable services: a mismatch that takes a while to unwind once the debt is called due.

"Regardless of whether a current specialization is the result of climate, geography or past government policy, the fact that it is a current specialization is what matters." In a sense, that's correct, but the problem with such thinking is that is either too short-term or too long-term. The key here is the cost of changing specializations. If changing regulations, for example, make an industry uncompetitive in a given geography, those changes can happen quickly, and wipe out a lot of value out of an economy. Protectionism (foreign or domestic) can do the same thing. But geography, demography, and the natural evolution of the industry are slower forces that tend to affect smaller blocks of people. Labor and capital can see competitive advantage changing in enough time that most of the dislocations can be covered by natural attrition and lack of new investment. Trade wars and recessions are not so kind.

So you say, if we don't protect domestic companies from foreign competition, we'll end up sending our dollars to foreign companies. Rather than spend those dollars in the United States, the foreigners lend them to our government. This debt is a drag on the economy, and therefore we should protect domestic companies from foreign competition. You seem to have more faith than I that politicians take into account the rate at which they borrow on other people's money! And why should they? Most will be out of office before the backlash comes, and current politicians can always blame the last guy.

Let's say we do protect domestic companies, say with a tariff on imports. Government debt is not going to be lower, because politicians just don't have the incentives to make it lower. If anything, it will be higher in the long-run as these protected domestic companies fail to adapt to the global market and need bailouts. With protection, more dollars will stay in America, but so what? Those dollars are worth less, because they have to pay either the higher prices of domestic companies, or the tariff. We've given up valuable goods to hold on to slips of green paper. (Which is exactly the point Friedman made in the video.)

For your second point, regarding the cost of changing specializations, I think you're right. Changes in government policy can rapidly wipe out large amounts of value. Which is precisely why the government should stay out of trade. The less involved it is, the fewer chances it has to wipe out value.

I'm trying to keep separated two concepts: what's truly happening, and what, if anything, we ought to do about it. So in response to "So you say, if we don't protect domestic companies from foreign competition, we'll end up sending our dollars to foreign companies", I would say first that I'm not at all worried about sending dollars to foreign companies. Sending dollars to foreign governments is more of a concern. I will also grant that not living on debt is the more important problem than any management of trade. But I really haven't far with prescriptions yet: I'm still working on the analysis.

It's true that democratic governments, while relatively free of despotic tendencies, aren't exactly known for their discipline: they try to give everything to everybody. This is why the more fiscal conservatives are Republicans and the liberals go by the name Democrats.

"Let's say we do protect domestic companies, say with a tariff on imports..." I hope we can agree that very serious foreign protection is hurting us on a lot of fronts. What to do about it is a much more difficult question. On an individual basis, responding with a tariff is a losing game, as the traditional graph shows. However, showing no serious response of any kind to *any* foreign protectionist measure makes you a target for any foreign entity that prefers to use subsidies for various purposes (jobs, national pride, military capability, cyber-military capability, etc.). We do not generally consider the aggregate cost appropriately.

The most important component of a "solution" to the debt problem would be not to borrow.

Absolutely, government has no business managing trade currently in the general case. The academic knowledge base to do it doesn't seem to be there, so heaven help a politically-based management scheme! There are important specific exceptions that ought to be considered, regarding national security. Opposing currency manipulation may be within the realm of what government can actually accomplish.